Chapter 7 Measurement Applications Accounting for Goodwill

Overview
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
CURRENT VALUE
ACCOUNTING
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Current Value Accounting
0 Movement of accounting practice to current value-
based financial statements is pointless if it sacrifices
reliability for more relevance.
0 Why there is skepticism about RRA.
0 Why managers, investors and auditors prefer
conservative accounting as opposed to current value
accounting.
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Current Value Accounting
0 2 bases of current value measurement
0 Value in use
0 Measure by discounted present value of cash expected to be
received/paid from asset/liability
0 Relevant info
0 Informs investor about firm’s future
0 So value in use is relevant, BUT it depends on how it’s
used and management changes
0 Example: financial instrument that decreases in value 
Management can declare holding it to maturity, avoiding
writedown
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Current Value Accounting
0 2nd base for current value approach: fair value or exit
value
0 Definition of fair value
0 Price that would received to sell an asset or paid to
transfer liability
0 Exit price = opportunity cost to firm of the intended
use of asset/liability
0 Due to market inefficiencies, fair value hierarchy is
needed.
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Current Value Accounting
0 Fair value hierarchy
0 Lvl 1: assets/liabilities which well-working market price
exists
0 Lvl 2: assets/liabilities which market price can be
inferred from market price of similar items
0 Lvl 3: assets/liabilities which market value cannot be
observed or inferred. Firm would use best available info
about how to value them.
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Current Value Accounting
0 Different impacts of types of accounting on income
statement
0 Under historical accounting ,net income is result of costs
and revenue, revenue being recognized when incurred.
0 Under value in use accounting, net income is accretion
of discount.
0 Under fair value accounting, net income depends on
management stewardship
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Longstanding Measurement
Examples
0 Examples of current value-based measurements in
GAAP
0 Accounts Receivable & Payable
0 Accounts receivable and payable are measured at
expected amount of cash to be received or paid.
0 Due to short time period, discount factor is neglected.
0 Cash flows fixed by contract
0 Long term debt often have fixed interest and principal
payments.
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Longstanding Measurement
Examples
0 Lower-of-Cost-or-Market Rule
0 When net realizable value of inventory falls below cost,
it’s written down.
0 When NRV increases, inventory is written up, but not
above cost.
0 Revaluation option for Property, Plant, Equipment
0 PPE can be valued at fair value, if it can be done reliably.
0 Once revalued, it must be kept up to date.
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Longstanding Measurement
Examples
0 Ceiling Test for Property, Plant, Equipment
0 Impairment loss for PPE is recognized if book value is
greater than recoverable amount
0 Recoverable amount = great of fair value less costs to sell or
value-in-use
0 Pensions and Other Post-Employment Benefits
0 For defined benefit pension plans, pension expense
arising from current period employee service includes
change in the discounted present value of expected
future pension payments.
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
FINANCIAL INSTRUMENTS
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Financial Instruments
0 a contract that creates a financial asset of one firm
and a financial liability or equity instrument of
another firm
0 Can you give an example of a financial instrument?
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Financial Instruments
0 Financial asset is:
0 cash
0 equity instrument of another firm
0 contractual right
0 to receive cash or another financial asset from another firm
0 exchange financial instruments with another firm under
conditions that are potentially favourable
0 Financial liability is:
0 Contractual obligation
0 deliver cash or another financial asset to another firm
0 exchange financial assets or financial liabilities with another
firm under conditions that are potentially unfavourable
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
IAS 39
0 IAS 39 classifies financial assets into four categories:
0 available for sale
0 loans and receivables
0 held to maturity
0 financial assets at fair value through profit and loss
0 IAS 39 classifies financial liabilities into two
categories:
0 financial liabilities at fair value through profit and loss
0 other financial liabilities
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
FVO
0 Fair value option – under this option, the firm can
opt to value financial assets and liabilities at fair
value, even though fair value is not required. Once
chosen, the firm will generally continue to fair-value
asset or liability in subsequent periods.
0 Why would firms have incentive to use the fair value
option?
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Incentive?
0 Firms have strong incentives to transfer assets
between classes, i.e. a transfer from held to maturity
to held for trading categories would trigger an
immediate increase in net income if the transferred
securities had gained in fair value
0 However, IAS 39 gives disincentives, should this
happen IAS 39 prevents use of the held to maturity
category for two years, thereby eliminating the firm’s
ability to value the financial instruments at amortized
cost for this period.
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Fair value?
0 Why not value all financial instruments at fair value?
0 Because sometimes reasonably reliable measurements
cannot be attained
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Deposits
0 Core deposit intangibles – arise from customers’
acceptance of a lower-than-market rate of interest on
their deposits, due to goodwill, habit, location, etc.
0 Example: supposed a bank pays 1% interest on a
customer’s $100 deposit lends the customer’s money
at 5%. As long as the customer keeps the deposit, the
bank’s deposit liability is accompanied by a core
deposit intangible asset that will generate $4 per year
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Problems?
0 IAS 39 does not allow for fair value accounting for
demands deposits due to the unreliable nature of
measuring intangibles
0 Mismatch arises when some assets or liabilities are
fair-valued but related liabilities or assets are not
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Example
0 Many firms hold financial assets and liabilities with
similar duration and other characteristics. These
create a natural hedge of changes in values.
0 Thus, a firm with long term debt issued at a fixed
interest rate may hold fixed interest bearing securities
of similar amount and maturity. This debts fair value
will change with rising or decreasing interest rates
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
IAS 39
0 Stipulate that certain securities (held-to-maturity)
need not be carried at fair value and that unrealized
gains and losses on others (available-for-sale) are
included in other comprehensive income
0 Reduce mismatch by adopting fair value option so that
“both sides” of the natural hedge are fair-valued
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Allen and Carletti (2008)
0 Model in which banks and insurance firms hold both
long-term and short-term financial assets
0 Can’t pay claims? Liquidate all assets, generating
liquidity pricing
0 Liquidity pricing drives market price below value-inuse
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Predictions
0 The model predicts that historical cost accounting is
socially preferred to fair value, since it avoids the
possibility of financial contagion from one industry to
another when the industries hold similar assets in
common
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Sapra (2008)
0 Points out the A and C model does not allow for
governments containing contagion
0 If returns on the long-run asset are correlated over
time, fair value accounting can give warning of
impending bank failure, giving governments a chance
to step in before deterioration
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
A and C
0 Helps to show how financial distress can spread
across the financial services industry and to
understand why financial firms are usually the
strongest opponents of fair value accounting.
0 Model is too strong in its blanket condemnation of fair
value accounting
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Plantin, Sapra, and Shin
(2008)(PSS)
0 PSS assumes that financial institutions know the
value-in-use of their liquid assets. However, if sold, the
proceeds will be less than value-in-use, for two
seasons:
0 loans are difficult to value by prospective purchasers in
the market, who do not have access to all the value
information possessed by the institution
0 since loan market is so liquid, selling assets lowers their
price, similar to liquidity pricing in the AC model.
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
FAIR VALUE ACCOUNTING
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
FAIR VALUE ACCOUNTING
0 Managements Preference.
0 If you were management what would you prefer? Fair
value or cost accounting
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
The 2008 Market Melt down
Crisis
0 Post Recession Huge Fair value write downs.
0 Assets to be written down to market value
$10,000
$2,000
0 If you were management what would you prefer? Fair
value or cost accounting
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
The 2008 Market Melt down
Crisis
0 Standards Severely criticized by Management and
Banks.
0 Economist report Sept 18th 2008
0 IASB and FASB rewrite standards
0 Fair Value when Markets are inactive?
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Outcomes
0 Project to replace IAS 39
IFRS 9
0 Effective January 1st, 2013
0 Fair Value at acquisition
0 Re-value at acquisition unless firms business model is
to hold assets for principle and interest. (Backing off
somewhat from Fair Value)
0 FASB does not allow for business model concept.
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Derecognition and Consolidation
0 Major Contributors to the 2007 – 2008 Financial crisis
0 Off Balance sheet Financing
0 Failure to consolidate these entities that held many
derecognized assets
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Derecognition vs. Securitization
0 When can an asset be removed from the balance
sheet? And the resulting revenue be recognized
0 Usually this is completed at point of sale
0 However what happens when we treat transferred
assets as secured borrowing?
0 Derecognition can improve the firms ratios considerably
0 Niu and Richardson (2006) study, 103 firms
0 If securitized their transfers instead of derecognizing
them
0 Debt to Equity: 5.97
10.20
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Lehman Brothers
0 2008 Collapse – used derecognition and consolidation
0 Repurchase Agreements @ 105% – treated as sales
0 Allowed under FASB rules at the time
0 Completed Transaction under U.K. subsidiary’s statements
0 Led to improvement of parent companies statements when
consolidated
0 SEC filings from Nomura, Santander and Merrill Lynch
have all acknowledged the heavy use of off-balance sheet
repo-to-maturity transactions. 2011
0 More recent – MF Global’s Bankruptcy in October 31st 2011
$1 Billion in equity supporting $40 Billion in Assets
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
? of Liability
0 When should a firm be allowed to derecognize a
transferred asset?
0 In 2008:
0 Under IAS 39 – it was “substantially all” of the risks and
rewards of ownership
0 Under FASB – it was to “surrender control” of the transferred
asset.
0 In 2009:
0 New exposure draft for amending IAS 39
0 States derecognition is allowed when transferring firm no
longer has the ability to obtain all future economic benefit of
the asset.
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Implications
0 Prior to the Meltdown Investors did not have enough
information to fully evaluate off-balance sheet
activities
0 With the additional disclosures required standard
setters hoping to avoid allowing companies access to
practices that contributed to the meltdown
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
DERIVATIVE INSTRUMENT
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Derivative Instruments
0 Derivatives instruments are contracts and their value
depends on price, interest rate, foreign exchange rate,
or other variables
If the market price of the
shares go up, what will
happen to the value of the
option?
BUY (call option)
100 shares of common
stock for $30 each =
$3,000
Characteristic of Derivative instruments is that it requires settlement in cash
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Difficulties Accountants Face
to Value Derivatives
0 The low initial investment characteristic of derivatives
is a reason why accountants have found them difficult
to deal with under historical cost accounting.
0 It is impossible for investors to figure out firms
derivative dealings, that is why accountants have
asked for supplemental disclosure
0 IAS 39 – All derivatives be measured at fair value for
balance sheet purposes
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
How to value derivative?
0 Fair value is measured by its market value
0 Example: (Call option: 100 shares for $30 each). Current market
price of the shares is $28 per share
3,000
2,800
2,600
Share
Value
Option
Value
3,200
200
0.25
2,800
0
0.50
2,400
0
0.25
Probability
0 Assumptions: The option can be exercised at the end of 2 months, Share
prices change at the end of each month, share price can go up by $2 with the
probability of 50% or go down by $2 with the probability of 50%.
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Hedge Accounting
0 Derivate instruments designated as hedges of
recognized assets and liabilities are called fair value
hedges.
0 If a firm owns a risky asset , it can hedge the risk by
acquiring a hedging instrument
0 Hedging instrument: some other asset or liability
whose value moves in the direction opposite to that of
the hedged item.
IAS 39
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Difference between hedged
item and hedged inventory
0 Example: During the year, a firm is concerned that
selling prices of the inventory will decline, hedges the
price risk on its inventory by entering into a forward
contract to sell the inventory at its current market
price.
0 Hedged item: inventory
0 Hedged instrument: forward contract
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Cash flow hedges
0 Firms may hedge anticipated transaction to reduce
the risk arising from price change of the firm’s future
production
0 Management must designate the instrument as a
hedge, identify the hedged item and document the
nature of the risk
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Highly effective
0 There is high negative correlation between the fair
values of the hedging instrument and the hedged item
0 One way of estimating this correlation is the
cumulative dollar offset method
0 Example: firm borrows at a variable interest rate.
Hedges its cash flow risk by purchasing a treasury bill.
Interest payment increased by $1500 and fair value of
the treasury bill is $1300. the ratio of loss to gain is 1500/1400 = -1.15
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
ACCOUNTING FOR
INTANGIBLES
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Accounting for Intangibles
0 Intangibles are capital assets that do not have physical
substance.
0 Examples??
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Intangibles
0 Most intangibles accounted for like property, plant
and equipment
0 If purchased or self-developed with certainty of future
net benefit they are valued at cost and amortized over
their useful life.
0 If acquired with business acquisition then are
recorded at a fair value determined reliably or at
acquisition cost.
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Research Costs – Intangibles
0 Since intangibles value is spread over many years
despite no assurance of future benefits, research costs
are not allowed to be amortized.
0 IAS 38: research costs must be charged to expenses as
incurred.
0 Self developed intangibles are most effected by this
rule; do not appear on balance sheet
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Goodwill – Intangibles
0 During an acquisition of a business accounting
required value of business be recorded using fair
values for: tangible assets, intangibles assets, and
Liabilities
0 Goodwill is the difference between the net amount of
fair values and total purchase price paid by acquiring
company
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Issues with Goodwill
0 Management had issues with the way Goodwill was
amortized after an acquisition.
0 After an acquisition, amortising caused consolidated
net income to drop and thereby made investors
question the business’s strategy of the acquisition.
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Issues with Goodwill
0 To respond to this management created ways to show
income earned without Goodwill Amortization.
0 Pooling of interests – Eliminated in USA 2001 and
Internationally in 2004
0 Pro-Forma income – Net income before goodwill
amortization, restructuring costs, other items.
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Issues with Goodwill
0 Standard setters responded in 2001 with SFAS 142
and IAS 36 with standard of measurement
0 Goodwill was now to be retained on consolidated
Balance sheet at time of purchase value and only
wrote down in case of impairment
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Self-Developed Goodwill
0 No identifiable transaction exist to determine the
costs of self developed goodwill
0 Costs that help create Goodwill such as R&D are
written off as incurred.
0 Therefore a recognition lag occurs when the goodwill
finally shows up after making abnormal earnings in
subsequent income statements.
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Self-Developed Goodwill
0 Lev & Zarowin (1999) argue that costs relating to self
developed Goodwill should be made transparent as it
would give a signal to investors of a firms future
profitability.
0 However it also could lead to over investment in R&D
by firms due to increases in share prices as a result of
investment
0 Standard setters reluctance is due to concerns about
reliability.
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Intangible Assets - Summary
0 Biggest issue for intangible assets is measurement of
value
0 Even during purchased goodwill, the value is still
somewhat arbitrary and useful life is estimated.
0 Standard setters provide some framework to assist in
decision making, but far from perfect
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
REPORTING ON RISKS
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Stock Beta
0 Is stock beta the only firm specific risk measure for an
investor with a diversified portfolio?
0 Beta is subject to estimation risk
0 Beta and certain financial-statement-based risks are
correlated
0 Can indicate direction and magnitude of change in beta
faster than market model
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Beaver, Kettler and Scholes
(1970)
0 Dividend payout ratio= common share cash dividend/ net income
0 Leverage= senior debt securities/ total assets
0 Earnings variability= standard deviation of firm’s price/earnings
ratio
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Differences in findings
Hamada
Lev
Ryan (1997)
• Off-balance sheet
• Separate fixed and
liabilities should be
variable operating
brought onto
costs for investors
balance sheet at
who want to infer
current value.
beta from financial
• Measurement of
statements.
debt in debt-equity
ratio is improved.
• Ex. IAS17 for finance
leases
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
• Concludes that
absorption cost
accounting, which
includes fixed
operating costs in
inventory, increase
difficulty of
evaluating operating
leverage.
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
WHY?
0 Why manage firm specific risks?
0 Why accounting standards require disclosure of firm
specific risks and how they are managed?
0 Reduce estimation risk
0 Reduce cash flow risk by hedging
0 Reduce speculation risk
0 Reduce credit risk
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Disclosures
0 IAS 39 and related FASB standards require:
0 Supplementary information about exposures to market
0 Credit risks
0 Firm’s risk management policies
0 BBL found that relevance of fair value reporting
outweighs reliability difficulties in measuring loan
value
0 Hodder, Hopkins, Whalen (2006) concluded that
comprehensive income contains relatively small
information about bank’s interest rate risk
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Price risks
0 Wong (2000) found that share prices of some of the firms
in sample were affected by foreign currency
0 One explanation is that investors have fully diversified
0 Wong attributes this to shortcoming of disclosure in
financial statement about
0
0
0
0
0
Hedging
Notional amounts
Fair values
Long and short positions
Maturities by class of instrument
0 Much of these are now required in disclosures
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Measurement Approach
0 Shift from communicating in MD&A to increased
measurement and analysis
0 Sensitivity analysis
0 Impact on earnings, cash flows, or fair values of financial
instruments resulting from changes in commodity prices,
interest rates, and foreign exchange rates
0 Value at risk
0 Loss in earnings, cash flow, or fair values resulting from future
price changes sufficiently large that have a specified
probability of occurring
0 IFRS 7 requires sensitivity analysis of price risks
0 Away from MD&A (securities commission regulation) into
supplementary financial statement information (accounting
standard)
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Microsoft Reporting
0 Microsoft is a big user of value at risk
0 Hedges options and other derivatives to face foreign
currency, interest rate, commodity, and securities price
risk
0 Uses value at risk to estimate unhedged exposure
0 In 2009, disclosed that 97.5% probability that loss on
assets will not exceed $211 million in one day holding
period
0 Investors know that one day loss of 1.4% of earnings is
unlikely
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Monitoring
0 If 10 price risks faced in portfolio, estimate
0 10 expected values
0 10 variances
0 45 correlations
0 Microsoft has previously disclosed that it monitors
1000 risks
0 Value at risk model does not include liquidity risks
0 Should it be included based on the 2007-2008
meltdowns in fair value of asset backed securities?
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Accounting for Goodwill
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Article: Accounting for Goodwill
0 New changes to accounting standards.
0 GAAP no longer amortize purchased goodwill
0 New categories of intangible asset values are separately
recognized
0 Goodwill is to be carried on the financial statements, with
exceptions, at its fair value
0 The fair value of goodwill and useful life of other intangibles
need to be assessed yearly pursuant to an annual impairment
test
0 All noncurrent intangible assets other than goodwill will need
to be depreciated or amortized over their useful life, unless
the asset life is determined to be indefinite.
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill
Article: Accounting for Goodwill
0 A detailed discounted cash flow model should most
frequently be used to determine fair value
0 The focus of goodwill is now on its fair value.
Current
Value
Accounting
Financial
Instruments
Fair Value
Accounting
Derivative
Instruments
Accounting
for
Intangibles
Reporting
on Risks
Accounting
for Goodwill